Will potential US interest rate hike trigger FII selling in Indian markets? Here’s what analysts say

Major central banks around the world have resorted to raising interest rates to tackle inflation. The largest among global central banks, the US Federal Reserve raised its benchmark federal funds by 500 basis points (bps) to a range of 5% to 5.25%, in its tightening cycle.

Fed Chair Jerome Powell said more interest rate increases may be needed this year to tame inflation while keeping the rates steady in its latest policy meet.

Following Fed’s steps, the Reserve Bank of India’s (RBI) Monetary Policy Committee (MPC) has raised repo rates by a total of 250 basis points to 6.5% since May 2022. However, it hit a pause button in April and June, reiterating that the pause was not a pivot and that rates would be raised if warranted.

Read here: Fed Chair Powell signals higher interest rates, says inflation fight ‘has a long way to go’

With this, the interest rate differential between India and the US has narrowed to 125 bps, raising concerns in the domestic market over potential foreign capital outflows.

The foreign portfolio investors (FPI) have invested nearly ₹60,000 crore in the Indian equities so far in 2023, data from National Securities Depository Ltd (NSDL) showed.

"As growth comes back ... inflows are returning — they are affected more by growth prospects. Moreover, a lower inflation differential makes a lower nominal interest rate differential feasible," Ashima Goyal, one of the three external members in RBI’s MPC told Reuters.

“The size of interest-sensitive inflows is not large,” she added.

Analysts, however, also do not expect any major selling in Indian equities by foreign investors in the near term.

“It is very difficult to say that FIIs will reduce their exposure in emerging markets such as India after comments from the US Fed on interest rates. There are 50-50% chances of it,” said Vinod Nair, Head of Research at Geojit Financial Services.

However, Nair believes that falling crude oil and commodity prices will help cool down inflation which is already on the downtrend. Moreover, policymakers in the US will also be watchful of recession when deciding upon interest rates.

“With the inflation downtrend expected to continue and fears of recession in the US, we may not expect any major decision on interest rates. Additionally, India’s growth story remains intact and foreign investors will stand attracted towards the Indian market,” Nair added.

Sudip Bandyopadhyay, Group Chairman, Inditrade Capital also does not expect any major risk of FII selling in the near term as he believes better corporate performance and resilient domestic macroeconomic situation will keep investors luring.

“Though Powell has indicated interest rate hikes this year, these are only talks and nothing concrete in it. What will influence investors is when the US actually raises interest rates. However, the mood in the domestic market is somber and investors are cautious due to certain factors such as delay in monsoon,” said Sudip Bandyopadhyay, Group Chairman, Inditrade Capital.

On the valuations front, analysts believe the Indian market is still attractive and there is a possibility of further improvement even though the upside seems limited. 

“Valuations may see further 5-10% improvement. The corporate results have been good and with commodity prices going down, we may see EBITDA margin growth for Indian companies,” Nair said.

He believes there are many opportunities in the broader markets and companies with strong fundamentals in the Nifty 500 space will do well in upcoming quarters.

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